Foreign institutional investors (FIIs) investing directly in Indian stocks will have to face the prospect of paying a 10% short-term capital gains tax on their portfolio investments.

The Authority for Advance Ruling (AAR) on Monday gave a new dimension to the tax-treatment of income earned by FIIs investing directly in Indian stocks. In a landmark ruling given to US- and Canada-based Fidelity Group, the quasi judicial authority has ruled that the income from sale of Indian equities by the 38-odd off-shore funds managed by this group will be treated as capital gains.

What this implies is that the profits of these funds from investments in securities will be treated as capital gains and not as business income. In short, it could mean that they can only invest in shares and not trade in them.

The AAR provides a ruling on the potential tax liabilities of foreign investors operating in India. The latest ruling could mean that foreign portfolio investors may have to pay a 10% capital gains tax, if they off-load shares within one year of holding them. Investments in stocks, if held for a year or more, are exempt from long-term capital gains tax.

The ruling will, however, not have any impact on FIIs routing investments through Mauritius or Singapore. Mauritius does not tax capital gains and Mauritius-based FIIs are exempted from paying capital gains tax here. This benefit has now been extended to Singapore-based FIIs under the improved protocol on double taxation between India and Singapore, subject to certain conditions. A bulk of portfolio investments flowing into India is routed through Mauritius given the beneficial tax treatment accorded to firms registered there.

The AARs ruling comes as a blow to several US-based FIIs, who were hoping to get a capital gains tax waiver. These FIIs were banking on an earlier ruling by the authority to Fidelity Series VIII.

The AAR had held that the trading income of this company would be taxable only in the US and not in India as it did not have a permanent establishment (PE) here. After this ruling, around 38 FIIs of the Fidelity Group, having a similar structure and operating through sub-accounts, sought a ruling on the tax treatment on investments in shares in India. Although an advance ruling is binding only on the applicant and the tax department, it has a persuasive value as other taxpayers can quote this ruling. A copy of the latest ruling is awaited, but government sources have confirmed the latest development.